Dynamic Unraveling

This paper studies price and liquidity dynamics in the presence of costly short-selling when uninformed traders have limited willingness-to-pay to trade securities. In this setting, unraveling and Bayesian social learning interact to produce a novel mechanism, dynamic unraveling: Unraveling that generates signals that lead to future unraveling. Applying the theory, I show how dynamic unraveling explains low-volume crashes: falls in the prices of securities on low or declining trading volume. In this context, short-selling restrictions can make low-volume crashes more likely by intensifying dynamic unraveling, but liquidity injections have the opposite effect. This paper was accepted by Agostino Capponi, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.02412 .